Louis M. Giovanini, Plaintiff-appellee, v. United States of America, Defendant-appellant, 9 F.3d 783 (9th Cir. 1993)

The United States Internal Revenue Service ("the Government" or "the Service") appeals the district court's grant of summary judgment in favor of taxpayer in an action for refund of assessed taxes paid by the taxpayer on account of "recaptured" federal investment tax credits. The district court held that taxpayer's investment tax credits were not subject to recapture under Internal Revenue Code ("I.R.C." or "the Code") Section 47(a)¹  because statutory exceptions contained in Section 47(b) applied.²  The Government argues that the district court erred in failing to apply Treas.Reg. Sec. 1.47-4(a) (2).

The district court had jurisdiction pursuant to 28 U.S.C. § 1346(a) (1). Our jurisdiction rests on 28 U.S.C. § 1291. We review the grant of summary judgment de novo. T.W. Elec. Serv., Inc. v. Pacific Elec. Contractors Ass'n, 809 F.2d 626, 629 (9th Cir. 1987). We affirm.I. FACTS

Giovanini and eight other individual investors formed a small business corporation, Metro-West, that provided cable television service. The corporation qualified as a Subchapter S corporation³  for its taxable year ending in 1980 and continued as a Subchapter S corporation through March 31, 1982. In that time period the corporation purchased over $5 million worth of equipment and other depreciable property to expand its cable television network. The investment entitled the corporation to a 10% investment tax credit available under Section 38. This tax credit was computed on the basis of an expected useful life of between three and seven years for the $5 million investment in equipment that qualified as "Section 38 property."

Subchapter S corporations are taxed essentially as partnerships.⁴  Shareholders bear any tax liability and may claim applicable tax credits on their individual tax returns. I.R.C. Sec. 48(e) (repealed 1982). Accordingly, a pro rata share of the corporation's investment tax credit flowed through to each of the Metro-West shareholders. Giovanini's share amounted to $27,103, portions of which he claimed in taxable years 1980, 1981, and 1982.

In December 1980, Metro-West and Storer Communications, Inc. incorporated Storer-Metro Communications, Inc. ("Storer-Metro"), an Oregon corporation. Exercising pre-incorporation agreement rights assigned to them by Metro-West, Metro-West shareholders contributed $20,000 in exchange for a 20% collective interest in Storer-Metro.⁵  Storer Communications, Inc. contributed $80,000 for an 80% interest. On March 31, 1982, Metro-West merged with Storer-Metro. In what is characterized as a "triangular merger,"⁶  the Metro-West shareholders exchanged all of their stock in Metro-West and Storer-Metro for stock of the parent Storer Communications, Inc. Before the merger, Giovanini's interest in Metro-West was 5.279%, and in Storer-Metro, 1.056%. After the merger, his direct and indirect interest in Storer-Metro was 1.068%. The Section 38 property owned by the surviving corporation, Storer-Metro, continued to be used by the corporation. None of it was sold or otherwise disposed of by any party to the merger.

In 1986 the Service determined, pursuant to certain recapture provisions that apply to Section 38 property, specifically Sections 47(a) and 48(e) (2) and Treas.Reg. Sec. 1.47-4(a) (2), that Giovanini owed a deficiency tax based on the recapture of the total amount of his investment tax credit. Giovanini paid $40,582.86 ($27,103 representing the recaptured tax credit, plus interest). In June 1989 he sued for a refund in district court. In the Proposed Pretrial Order, taxpayer and the Government stipulated to uncontroverted facts. The Government specifically conceded that the merger of Metro-West into Storer-Metro was a transaction that qualified under Section 381(a) of the Code.⁷ 

This is a case of first impression. We are required to determine whether a statutory merger of a Subchapter S corporation into a C corporation within the terms of Sections 368(a) (1) (A) and 381(a) triggers recapture of investment tax credits from the Subchapter S shareholders under the recapture provision, Section 47, of the Internal Revenue Code. Specifically at issue is whether the exemption afforded by Section 47(b) (2) applies. Our analysis begins with the Code, "for where, as here, the statute's language is plain, 'the sole function of the courts is to enforce it according to its terms.' " United States v. Ron Pair Enters., Inc., 489 U.S. 235, 241, 109 S. Ct. 1026, 1030, 103 L. Ed. 2d 290 (1989) (quoting Caminetti v. United States, 242 U.S. 470, 485, 37 S. Ct. 192, 194, 61 L. Ed. 442 (1917)).

Section 47(a) (1) states that:

If during any taxable year any property is disposed of, or otherwise ceases to be section 38 property with respect to the taxpayer, before the close of the useful life which was taken into account in computing the credit under section 38, then the tax under this chapter for such taxable year shall be increased....

I.R.C. Sec. 47(a) (1). Section 47(b) exempts "certain cases" from the application of Section 47(a). Taxpayer claims exemption from recapture under Section 47(b) (2), which provides that "Subsection (a) shall not apply to ... (2) a transaction to which [S]ection 381(a) applies." Section 381(a) applies " [i]n the case of the acquisition of assets of a corporation by another corporation," if Section 361 applies, and if "the transfer is in connection with a reorganization described in subparagraph (A) ... of [S]ection 368(a) (1)." Section 368(a) (1) (A) defines a qualifying "A" reorganization as "a statutory merger or consolidation."⁸  To determine, then, whether Section 47(b) (2) applies, the court must engage in a triple-tiered inquiry. First, does Section 368(a) (1) apply? Second, does Section 381(a) apply? Last, does Section 47(b) (2) apply? Unless the fact the taxpayer is a Subchapter S shareholder brings into play some other limitation, if Sections 368(a) (1) and 361 apply, then Section 381(a) applies; if Section 381(a) applies then Section 47(b) (2) applies. Statutory interpretation proceeds in simple domino fashion, each statutory provision triggering the next.

The Government has stipulated that Section 381(a) applies.⁹  Nonetheless, the Government would have us reverse the district court's decision and recapture the tax credit. According to the Government, a more nuanced reading of the Code and its legislative history requires recapture. It argues as follows. A statutory merger, though a single transaction, is the product of two "events," first, an acquisition of assets, and second, an exchange of stock. The acquisition of assets occurs at the "corporate level" and the exchange of stock at the "shareholder level." The fact that the relevant provisions apply to the asset acquisition in which the Subchapter S corporation, Metro-West, participated does not mean that they apply to the exchange of stock by its shareholder. Any analysis of the tax effects on the shareholder of a Section 381 "statutory merger" is entirely separate from those that apply to the corporation. Thus, it can concede that all the relevant provisions mandating an exception to recapture apply with respect to the corporation, while maintaining that the shareholder, taxpayer Giovanini, nevertheless remains liable for recaptured investment tax credits. By reading this two-level-two-event theory of statutory mergers into the Code,¹⁰  it avoids the application of the Section 47(b) (2) exception to subchapter S shareholders.¹¹ 

Like the district court, we are not persuaded. We find nothing in the Code or the policy considerations elaborated in the legislative history that supports the Government's approach. In our view, if Section 47(b) (2) applies, it applies to the transaction as a whole. This is particularly so when the qualified transaction is defined as one accomplished by an exchange of stock. See I.R.C. Sec. 361; Or.Rev.Stat. Sec. 57.462 (effective Nov. 1, 1981).¹²  Moreover, the distinction between shareholder and corporation is unavailing in this context where whatever tax consequences the Code accords an S corporation participating in a qualified transaction necessarily pass through to its shareholders. See I.R.C. Sec. 48(e).

On their face, none of the applicable provisions draw a distinction between corporate and shareholder "events." None provide for different treatment of corporations as opposed to individual shareholders. In short, we find no support for the government's theory in the plain language of the Code. Nor, ultimately, are we persuaded by its alternative reading of the text.

The Government's textual argument begins with Section 47(a). It presses an interpretation of this provision, and those related to it, that would modify the plain meaning of both the general rule (Sec. 47(a)) and its exceptions (Sec. 47(b)). According to the Service, Section 47(a)'s¹³  language can be parsed to "provide [ ] for recapture in two situations": one where " 'property is disposed of' "; the other where property " 'otherwise ceases to be [S]ection 38 property with respect to the taxpayer.' (Emphasis added.)" Appellant's Opening Brief at 26 (citing I.R.C. Sec. 47(a) (1)). In its view, while transactions falling within the first clause of Section 47(a) (1) (where "property is disposed of") may be exempted by virtue of qualifying as Section 381(a) mergers, Treas.Reg. Sec. 1.47-4(a) (2)¹⁴  continues to govern transactions falling within the second clause (where property "ceases to be [S]ection 38 property"). Because, for reasons discussed below, an exchange of shares is not a Section 381(a) "event," the Service contends it falls under the second clause of Section 47(a) (1). Thus "property ceases to be Section 38 property with respect to a Subchapter S corporation shareholder where, as here, his proportionate stock interest in the corporation is reduced by a third or more." Appellant's Opening Brief at 28.

The Service also urges a complementary interpretation of Section 381(a).¹⁵  It reads the general language, " [i]n the case of the acquisition of assets of a corporation by another corporation," to limit the application of this Section to "corporations" and "corporate level events." Thus it deems Section 381(a) applicable to the "corporate" transaction or disposal of property, but not to the "shareholder" exchange of stock, which it characterizes as falling within the second clause of Section 47(a) (1). This exchange, it insists, is not part of the Section 381(a) transaction (and, consequently, not exempted under Section 47(b)), and so remains governed by Section 47(a) and its implementing regulations. It concludes that, by its own terms, Section 381(a) applies only to the "corporate" dimension of the statutory merger and that the exemption applies only at the "corporate level." With respect to a Subchapter S shareholder, then, whatever exemption from recapture the corporation is entitled to, under the Service's theory, would not redound to the benefit of the individual shareholders.

We disagree. Neither the text of the Code nor its tax treatment of S corporations supports the Government's argument. With respect to the textual reading, nothing in the language of Section 47(a) (1) or 47(b) (2) suggests that there should be a separate analysis for shareholders as opposed to corporations. There is no discussion of different triggering "events" for different "levels." In the first place, the particular reorganization in question here, a statutory merger, necessarily involved both the acquisition of corporate assets and the exchange of stockholders' shares. In compliance with Section 361, the reorganization consisted "solely [of an exchange] for stock." See Or.Rev.Stat. Sec. 57.462 (stock-for-stock exchange) (effective Nov. 1, 1981). Indeed, without the exchange of shares, the transaction would not have qualified under Sections 361(a) and 368(a) (1) (A). Notwithstanding any analytical distinctions one could impose, these "events" (the corporate acquisition of assets and the shareholder exchange of stock) function as the necessary components of a qualified statutory merger.¹⁶ 

Section 381's introductory language makes clear that a corporate transfer of assets from one corporation to another must be involved, and thereby precludes its application to partnerships or other noncorporate business forms.¹⁷  Beyond this prerequisite, Section 381(a) (2) is cast in intentionally broad terms. It provides for transactions "in connection with a reorganization."¹⁸  On its face the section does not imply, let alone require, that a distinction be drawn between corporate shareholders and the corporation. As we have pointed out, in light of the very nature of the mergers at issue, it would make no sense for it to do so. To exempt, piecemeal, a merger the Code specifically defines as necessarily both a "corporate" and a "shareholder" transaction would be to ignore the Code's stated definitions. Certainly, Section 381(a), in incorporating Sections 361(a) and 368(a) (1) (A), lends no authority to this position.

Not only is the Government's textual interpretation internally inconsistent, it is at odds with the Code's tax treatment of S corporations. In attempting to erect distinctions between S corporations and S corporation shareholders for the purposes of exemption from recapture, the Service disregards the pass-through nature of S corporation taxation. The tax liabilities and benefits of an S corporation qualifying for investment tax credits pass through to its shareholders. See I.R.C. Sec. 48(e); Treas.Reg. Sec. 1.48-5(a) (1).¹⁹  Subchapter S corporations may participate in mergers as described by Section 381(a). When they do, they are exempted from recapture tax liability. Because shareholders bear the tax liability of the corporation, if the corporation is not liable, they are not liable. Contrary to the Government's conclusion, supra, whatever exemption from recapture the S corporation is entitled to necessarily redounds to the benefit of the individual shareholders.

Once having conceded that the merger of Metro-West into Storer-Metro was a "statutory merger" within the terms of Section 381(a), the Government simply has no textual basis for according the Section 47(b) (2) exemption to the corporate entity but not allowing it to pass through to its shareholders--a scheme that would be wholly at odds with the tax treatment of S corporations.²⁰  Like the district court, we conclude that the merger is a transaction that exempts the tax credit from recapture under Section 47(b) (2). We, therefore, affirm the court's determination that Section 47(a) and Treas.Reg. Sec. 1.47-4 are inapplicable.²¹ 

B. Legislative History and Policy Considerations

The Service's extratextual arguments do not counsel a different result. The Government would have us deny the benefits of Section 47(b) (2) exemption to shareholders on the basis of Section 47(a)'s legislative history and policy considerations specific to Subchapter S corporations. We conclude that these sources neither require nor sanction abandoning the textual analysis employed by the district court.

The Government parses Charbonnet v. United States, 455 F.2d 1195 (5th Cir. 1972), and Ranier v. United States, 871 F.2d 607 (6th Cir. 1989), to explicate the purpose and legislative history of Section 47(a). Significantly, in neither case are the Section 47(b) exceptions to the recapture provision properly at issue. In Charbonnet, the taxpayer, previously the sole shareholder of a Subchapter S corporation which had declared a stock split, and who, after the stock split, retained less than a two-thirds percentage ownership in the surviving corporation, contested the validity of Treas.Reg. Sec. 1.47-4(a) (2), claiming that it was inconsistent with the "change-in-form" exception which he alleged applied. That court held that because "the exception ha [d] no applicability," Treas.Reg. Sec. 1.47-4(a) (2) would govern. Charbonnet, 455 F.2d at 1201. It did not hold that because Treas.Reg. Sec. 1.47-4(a) (2) applied, exception 47(b) (2) did not. Nor did it suggest that even if exception 47(b) (2) applied, it did not override the regulation. Both these arguments are made by the Government in this case, but they derive no authority from that court's explication of recapture policy in a case where no exception was found to apply. In Ranier, taxpayers sold all their stock to a third party and entered into an agreement that any recapture liability would be shouldered by the acquiring third party. They argued that, as a consequence of this agreement, the regulation was invalid as applied to them. The Ranier court upheld the validity of the regulation without engaging in any analysis of Section 47(b). No statutory exception was at issue.

Even if these cases were on point, they suggest no reason to withhold tax benefits from S corporation shareholders. Extending Section 47(b) (2) protection to a shareholder who, as in this case, can prove his entitlement to it is not at odds with the policies that underlie investment tax credit recapture.

In passing Section 47(a), Congress was concerned with preventing multiple credits by quick turnover of assets,²²  that would allow a taxpayer " [to bail] out early, [so that he] reaps a tax benefit without himself suffering the risk throughout the estimated useful life,"²³  and with the shifting of property "from a business to a personal use," or to a use "predominantly outside the United States."²⁴  It wanted to encourage an "overall investment pattern" that would "fully satisfy the ends of the investment credit."²⁵  Taxpayer has not engaged in any scheme to afford "multiple credits." He has not "bailed out" or extinguished his risk; he continues to participate as a shareholder (and risk-taker) in a larger cable television company which still puts the $5 million investment to use.²⁶  It appears that his "overall investment pattern" is to remain a participant in a presumably even more productive, larger cable television company that now holds the $5 million Section 38 property.²⁷  The Government's contention that taxpayer loses the tax credit because he has "bailed out" or abandoned his risk by diversifying and spreading that risk impermissibly stretches legislative history and the case law interpreting it. Essentially the Government reads Treas.Reg. Sec. 1.47-4(a) (2) into language that bears no trace of its percentage-based analysis.²⁸  In our view a regulation promulgated pursuant to Section 47(a)'s general recapture rule cannot, in the guise of underlying policy, purpose, or legislative history, negate the effect of a separate statutory provision expressly departing from that general rule.²⁹ 

Finally, the Service resorts to a mixed legislative history and policy argument to single out S corporations for unfavorable tax treatment under Section 47(b) (2). Ignoring its own concession that the transaction in which the S corporation participated did fall within the literal terms of the statutory exemption, it posits that, as a matter of legislative history, this exception may only apply "in the case of corporations where a successor corporation 'stands in the shoes' of the predecessor." Appellant's Opening Brief at 35-36 (parentheticals omitted).³⁰  The Service then contends that a "successor corporation does not 'stand in the shoes' of a predecessor Subchapter S corporation with respect to investment credits, because a Subchapter S corporation has no investment tax credit 'shoes.' " Id. The argument draws on the particular nature of a Subchapter S corporation as a flow-through entity in which tax attributes inhere in the shareholder, not the corporation. See I.R.C. Sec. 48(e) (1). While it is true that the district court erroneously relied on Section 381(c) (12) to confirm that "tax benefits" would carry over to the C corporation from the S corporation,³¹  other provisions of the Code and the regulations do address the carryover effects of a statutory merger so long as that merger is one to which Section 381(a) applies. I.R.C. Sec. 381(c) (23) (C.C.H.1981);³²  Treas.Reg. Sec. 1.47-3(e), 1.47-1 (C.C.H.1981).³³  See also Eustice & Kuntz, supra note 6, p 12.02.

Ultimately, the Government's argument that Subchapter S corporations are different from other business organizations is very narrowly cast. It does not contest that a Subchapter S corporation may participate in a statutory merger within the meaning of Section 381(a) in every way besides the carryover of tax benefits for Section 38 credits. The district court found "no material distinction between subchapter S corporations or other business entities anywhere in [S]ection 381 or 47." It declined to "read such distinctions into the statutes and assume [d] that Congress intended for shareholders of [S]ubchapter S corporations to receive the same treatment as other business entities." District court opinion at 11.

Notably, in October 1982, as part of the Subchapter S Revision Act, Congress enacted a coordinating provision for Subchapters S and C corporations. It makes clear that " [e]xcept as otherwise provided, and except to the extent inconsistent with this subchapter [Subchapter S], [S]ubchapter C shall apply to an S corporation and its shareholders." Prentice-Hall, Inc., Handbook on Subchapter S Revision Act of 1982, p 295 & n. 295 (1982); I.R.C. Sec. 1371(a) (1) (Callaghan 1993) (effective Dec. 31, 1982). Even in the absence of this coordinating provision, we agree with taxpayer's argument that its sense is implicit in the failure of Section 47(b) (2) or any provision in Subchapter S to exempt Subchapter S shareholders from such coverage.³⁴  In light of our analysis of the text, we decline to adopt the Government's reading of the legislative history of Section 47 to create a distinction in the Code with respect to the treatment of Subchapters S and C corporations under Section 47(b) (2).

Because the transaction at issue is a "statutory merger" within the terms of Section 381(a), and because Section 47(b) (2) encompasses transactions to which Section 381(a) applies, we find that the plain language of the Code supports exempting taxpayer from recapture of the investment tax credit claimed on his returns in tax years prior to the merger. We conclude that no legislative history or policy considerations militate against this holding. We reject the Service's position that, in respect to Subchapter S corporations, only the corporate entity, and not its shareholders, may benefit from the Section 47(b) (2) exemption. It is fundamentally at odds with the pass-through tax treatment of S corporations. Like the district court, we discern no intent on the part of Congress to disadvantage S corporations and their shareholders in this way.

AFFIRMED.